As Canadians seek ways to gen-erate income in retirement amid the decline of workplace pensions, annuities are poised to play an increasingly important role in client portfolios.
“More and more people are going into retirement without a pension being provided by their employers,” says Peter Wouters, director of tax and estate planning with Kingston, Ont.-based Empire Life Insurance Co. “So, you have to figure out a way of ‘pensionizing’ the assets you have into an income stream. An annuity is one of the options.”
An annuity is an insurance product that provides a series of future payments to a client in exchange for an initial lump-sum investment. The payments can be guaranteed to last for the duration of the client’s life (in the case of a life annuity) or for a specified period of time (in the case of a “term certain” annuity.
“What annuities do is, for a certain part of [clients’] assets,” Wouters says, “allow [clients] to enjoy a guaranteed income flow without having to worry about market fluctuations and without having to make investment decisions.”
Destroy capital for income
However, annuities can be a tough sell, given that they essentially destroy the client’s capital in exchange for income. Life annuities, in particular, provide income for only as long as the client lives; the insurance company retains any remaining funds upon the client’s death. Thus, clients who hope to leave an inheritance for their children generally aren’t interested in annuities.
“It’s a very difficult sell,” says Bruce Cumming, executive director, private client group, and senior investment advisor with HollisWealth Inc. (formerly DundeeWealth) in Oakville, Ont. “People don’t want to give up control of their capital.”
And there is another factor making the products even harder to sell, says Moshe Milevsky, associate professor of finance at York University’s Schulich School of Business and executive director of the Individual Finance and Insurance Decisions Centre: “As interest rates have declined, annuity yields have declined.”
This situation has some clients convinced that they should wait to buy an annuity once interest rates rise.
Yields higher than for GICs
As the payouts on annuities comprise both invested capital and interest, however, those yields continue to be substantially higher than yields on guaranteed investment certificates (GICs) and other fixed-income products. A 65-year-old male who purchases a $100,000 annuity today, for example, could expect to receive payments of about $7,000 a year for the rest of his life. That’s far more appealing than the roughly 2% that a client would earn on a GIC, Cumming says: “Every year, the client [with the annuity] is 5% ahead of the game.”
Cumming argues that clients shouldn’t let interest rates determine when they buy an annuity. Although a rate increase could have a positive impact on annuities’ yields, it also would negatively affect the client’s existing fixed-income holdings.
“The very thing [clients are] waiting for — interest rates to go up — is going to hurt their existing portfolios,” Cumming says. “So,[if they wait,] they’ll have less money to buy their annuity.”
When short-term interest rates do rise, he adds, the impact on annuity yields may not be quite as drastic as clients expect. “Rising rates affect only one- to five-year [investments],” Cumming says. “It does not have much of an impact on annuities because annuities are priced off 20-, 30- and 40-year interest-rate investments.”
Furthermore, interest rates aren’t the only factor used to set annuity prices. Factors such as average lifespans can play a role; and, with Canadians living longer, annuity rates could trend lower over time.
Despite annuities’ lower rates, however, they continue to hold value — particularly for clients who are concerned about the prospect of outliving their money.
Averaging out annuity payments
The ideal time to buy an annuity is when the client stops working and begins needing a stream of income to cover fixed expenses. As annuity rates can be considerably higher as the client gets older, however, age should be a consideration.
A 75-year-old male could expect to receive almost $10,000 a year on a $100,000 annuity vs $7,000 at age 65. To benefit from the higher rates, some clients may want to consider annuitizing some of their assets at age 65, Wouters suggests, and some clients may want to do that later.
“You’re older,” Wouters says, “so your payment is going to be that much higher. You’re kind of averaging everything out.” IE